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FROM: JUL-AUG 2008 ISSUE
Sooner or later, when considering a major business deal, the CEO and strategic team will arrive at a Rubicon moment. The go or no-go decision will depend on the information they use to calculate the bottom line. How much value will shareholders see?
You know how challenging it is to define the value of a business asset. Maybe you rely on traditional accounting methods to show how much a company, or an asset that company would like to acquire, is worth. But traditional accounting is based on historical costs. Value – real business value – is about the future, not the past.
It is also increasingly about assets other than bricks and mortar. Much of the value of companies today, as seen by potential purchasers or investors, is based on intangible assets such as brands, contracts and the expertise of employees. That’s what often makes the art of the deal so much like finding things in the dark.
Chartered Business Valuator Stephen Cole of Toronto says, “In some cases, particularly with emerging technology companies or distressed companies whose recent past has not been successful, it’s difficult to determine their value – because value is all about the future and there is no historical guide.”
“The valuation of something that can’t be seen is very subjective,” says Carl Merton, CEO of Reko International Group Inc. in Windsor, Ontario, and secretary-treasurer of the CICBV board of directors.
“If I buy a building for $1 million, I can show that on my financial statements, but if I hire an employee who is brilliant and helps me to build better products for my customers, then how do I record that as an asset on my books? I can’t, because of the historical cost basis of accounting.”
“The distinguishing qualification of a CBV is expertise in determining a likely asking price to be expected in the market for an asset – the value,” says Donald Spence, a managing director of Spence Valuation Group Inc. in Kelowna and Vancouver B.C.
“The skill set gained through experience and training puts a CBV in a position to identify the value drivers in any business. From a CEO’s perspective, that is important because it is his or her task to increase the value of a business.”
The corporate status of CBVs is rising. Since 2000, the dot-com bust and revelations of corporate accounting malpractices have made executives and investors more careful about the value of assets. New accounting standards, too, have raised the importance of business valuations. But a major reason why CBVs are more frequently called upon as strategic advisers is that they help companies make better decisions.
Stephen Cole, Managing Partner of Cole Valuation Partners Limited, says the advice of a CBV can keep busy executives “grounded.” As an example, his firm recently provided advice to a publicly traded company that was considering buying a privately held technology firm. Cole recommended against paying a lump sum cash price for the company, since its value relied almost entirely on intangible assets and could not be accurately estimated.
Instead, the client followed Cole’s advice to “drip-feed” the target – that is, to obtain an option to purchase in exchange for lending money to the firm. After a year of acting as a lender, during which time the public company gained a thorough understanding of the technology firm and conducted due diligence, it completed the acquisition on favourable terms.
“It’s important not to get caught up in the chase,” Cole says. “Often, aggressive CEOs with growth mandates don’t take enough time and care with acquisitions. A CBV can help them keep value perspectives in mind.”
CBVs across the country report that their clients are now seeking their advice early in the process of making major decisions. Sometimes the result is that a proposed transaction is cancelled. In Montreal, Denis Labrèche, partner, valuation and business modeling, Ernst & Young recalls several incidents in which clients took his advice to walk away from proposed acquisitions of technology companies.
“With our rational approach to value, we avoided horror stories,” Labrèche says. Tom Strezos can claim the same kind of satisfaction. He leads the private client service group for litigation and valuation services in Toronto at Deloitte’s. Recently, a client was interested in purchasing a company in the health-care industry. But the Deloitte valuation team found that the target company’s stated value was not there. Financial statements were not in order, and some claimed contracts didn’t exist.
“It was fortunate that we got involved before they signed a deal,” Strezos recalls. “The target company eventually went bankrupt, and our client almost bought them for $8 million!”
In another instance, involving a lawsuit, Strezos’ client was suing a former partner who had left the firm and taken a contract with him, contrary to a non-compete agreement. The client estimated the value of the loss at up to $100,000. Strezos says: “They used a net-income approach but we used a contribution-margin approach – sales less variable expenses. We worked with the company’s lawyer to develop a true understanding of the losses, and put together a report that the company had in fact lost more than $750,000.” The case settled very favorably.
Such discrepancies can be very confusing. What causes them? It’s not necessarily a matter of one party being right and the other wrong. Perspectives vary; market conditions change. CBVs are the first to admit that valuation is an art, not a science. The artistry of the CBV, however, is recognized and acknowledged by the legal system.
“We’ve been trained to establish value,” Denis Labrèche points out. “We have various methodologies; we don’t look at a company only one way, because there are different ways to evaluate a business. But that’s our specialty. Others do it only on a part-time basis.
Buying and Selling a Business
Businesses of all sizes rely on CBVs to provide expert valuations for many kinds of business transactions. Often these involve the sale or transfer of a business by its owner. It’s a growing trend. In the coming decade, a great many business owners will be retiring. How much will they be able to realize from their businesses to support their retirement? Part of the answer, as every CBV knows, will probably depend on things that the CEO may not have thought about.
How marketable is the business? Are its financial statements and management information systems up to date? What is the future value of its contracts and other intangible assets? And what is the growth potential of its market? Such questions and many more are sometimes outside of the owner’s comfort zone. Many entrepreneurs take great pride in their businesses, especially the physical premises they have built.
“A prospective seller often looks at the bricks and mortar, but the true value of the business is based on the profit it can generate in future,” says Denis Labrèche, who has helped sell businesses for a quarter of a century. “An entrepreneur sometimes looks on a business like a son. What a CBV can do is to take the emotion out of the sale, understand the buyer’s perspective and bring a financial rationale to the process.”
Donald Spence, past president of the CICBV, who has written a book called Selling your Business For What It Is Worth, says that perceptions of buyers and sellers can sometimes be opposites. What an entrepreneur might see as a strength, such as his or her own decision-making ability, might be viewed as a weakness by a buyer looking to the future.
“I did a valuation of a steel-fabrication business in B.C. about 10 years ago, for an owner who was buying out a shareholder,” Spence recalls. “The valuation highlighted many weaknesses in the business, as well as positives. One negative was its absolute dependency on the owner to do everything. That was a significant limiting factor in the growth of business. Also, if the owner was planning to sell, a buyer would see the business as highly risky.
“Since then the owner has hired a management team, including a sales manager and a plant manager. Other things being equal, his company is of higher value today than it was seven years ago, because of the management depth.”
Similar kinds of issues come into play when businesses are passed to a second generation within a family. There’s the added complication that the founder wants to realize enough value from the business to meet the goals of both retirement and estate planning.
Business owners in such circumstances often “freeze” the value of their estates. That is, they will exchange their common shares for preferred shares, with a value fixed at a certain date. On death, their estates will be taxed only on the value of those preferred shares. Any additional value that is added to the company after the valuation date is allocated to the common shares that are issued to the sons or daughters who take over the business. Sounds good – but what is the underlying value of the business upon which the estate freeze is based?
“CBVs can help in structuring the estate plan and determining the appropriate values,” says Farley Cohen, managing director of Navigant Consulting in Toronto.“We can be a very productive part of the team, working with tax counsel, the estate lawyers, and the parties themselves.”
Another important aspect of succession planning is to have an insurance plan that helps cover estate taxes at death. CBVs can help in determining how much tax there is going to be, and how much insurance is necessary without being excessive.
Cohen says that too many CEOs of family businesses don’t know the importance of valuing their corporate assets before succession takes place.
“A lot of people don’t deal with this at all. If they did, there would be fewer family feuds. If people start planning early, and put succession plans in place properly ahead of time, things can be a lot smoother.”
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